Nov. 2, 2015
Thank you, Steve, for your kind introduction. Good morning and thank you for inviting me to speak to you today. Before I begin, let me remind you that the views I express are my own and do not necessarily reflect the view of the Commission, any of the Commissioners, or any other colleague on the staff of the Commission.[1]
It is a privilege to be here today to deliver the keynote address at this important conference on regulatory and compliance issues affecting investment products issued by insurance companies. I understand that tomorrow morning there will be a presentation reflecting on the SEC’s historical regulation of insurance products, as this year marks the 75th anniversary of the Investment Company Act of 1940. This anniversary is an important one for the asset management industry and the investors it serves. The Commission commemorated this anniversary at the end of September with a conference that included remarks from SEC Chair Mary Jo White and her fellow commissioners. The event also included a series of panel discussions, with participation from former SEC chairmen and division directors as well as prominent industry leaders.
The Investment Company Act established a comprehensive regulatory framework for registered investment companies, including mutual funds and insurance product separate accounts. It was enacted at a time when the industry held about $2 billion in assets, and before the introduction of variable annuity and variable life insurance products. Now, 75 years later, there are over $18 trillion[2] in registered investment company assets — approximately $1.5 trillion of which are held in variable insurance contracts.[3] The Act has stood the test of time with respect to an industry that has evolved considerably since 1940. Perhaps no one knows this better than those who work in the area of variable insurance, an industry that has grown and changed significantly since the introduction of the first variable annuity more than half a century ago.
Fortunately, the flexible framework established by the Act has allowed the Commission and its staff to provide effective regulatory oversight of an industry marked by constant and dramatic change over these seven and a half decades. Indeed, the staff in the Division of Investment Management is always working to: (a) facilitate registrants’ compliance with their legal and regulatory obligations under the Investment Company Act; (b) improve the regulatory framework under the Act in response to industry developments; and (c) provide enhanced guidance to registrants. This morning I would like to address how the Division staff is currently working to achieve these goals, particularly as they relate to the variable insurance industry.
In September, we mourned the death of the great Yankee’s catcher Yogi Berra, who famously said “when you come to a fork in the road, take it.” With regard to SEC staff involvement in compliance matters, we may well be at such a fork in the road. We face rapid developments in the investment management industry, to which we could take either of two approaches. We could react, or we could be proactive and get out in front of these developments. We are committed to the latter approach. For example, the Division staff has been quite proactive through its senior level engagement program, which is intended to encourage communication and foster valuable dialogue between the industry and the staff. Through this initiative, the Division has been bringing together in an informal, non-examination setting senior leadership within the Division and senior management and fund boards at various asset managers throughout the country. These meetings provide valuable insight and some practical, real world knowledge for the staff as to how the industry operates. They may also help inform the staff’s decisions as to Division priorities, as well as where staff guidance may be needed or where disclosure standards may need to be revisited.
Speaking of disclosure, I would like to apprise you of recent efforts by our Disclosure Office to evaluate staff comments on the various disclosures reviewed each year. The Division has taken on this project with several goals in mind, including consistency throughout the Office, assessing the effectiveness of staff comments as disclosure evolves over time in response to industry developments, and providing guidance to registrants with regard to important disclosure issues. You may be interested to know that one area that has merited increased focus by the Division is the variable annuity fee table, which has become quite complicated for many products, particularly with the inclusion of various guaranteed benefit riders. The impact of fees on an investor’s return is considerable. For that reason, our disclosure staff is looking for a clear and comprehensive fee table when reviewing variable annuity filings. In connection with this disclosure review project, the staff has reviewed hundreds of filings and searched through numerous comment letters and registrant responses. The beneficiaries of this project will be the registrant community, who should see more consistent and clearer staff input, and more importantly, the investor community, who should see better and more effective disclosure. The Disclosure staff will also benefit from enhanced coordination with regard to the filing review process.
While I’m talking about disclosure, I would like to offer an observation regarding a trend our disclosure review staff has noted among several variable product issuers. The staff continues to see buyout offers relating to variable insurance contracts with generous guaranteed income benefits and death benefits that, over time, have proven costly for insurance companies and their hedging programs in light of the ongoing low interest rate environment. Typically, existing contract owners are offered a pecuniary incentive such as an increase in contract value or a lump sum payment in exchange for the termination of the guaranteed benefits or even the surrender of the entire contract. Certain offers may include incentives for early annuitization, and often such offers are made contemporaneous with an offer to exchange all or part of the contract for another insurance contract issued by the insurer. These offers often limit an insurer’s exposure under existing guaranteed benefits, and may not be beneficial for all, or even most, contract owners. The staff will continue to carefully review the disclosure relating to such offers, and will be diligent in considering the impact of the offers on contract owners and seeking to elicit clear disclosure to investors. I encourage you to focus carefully on disclosures with respect to these offers — and also to carefully monitor sales practices associated with these offers.
I’d like to turn now to a few recent no-action letters that should be of interest to you. Two letters that may be particularly noteworthy in the variable insurance product space were issued this year to Jackson National Life Insurance Company[4] and to the American Retirement Association.[5] The Jackson National letter reinforced our historical position that Rule 24f-2 share registration fees need only be paid once in a conduit arrangement such as a master-feeder structure or an insurance company separate account holding shares of an underlying mutual fund.[6] Jackson National involved a three-tiered structure - an insurance company separate account investing in a master-feeder structure. The staff confirmed that it would not recommend enforcement action to the Commission if share registration fees with respect to a three-tiered arrangement were calculated and paid as though there has been a single share issuance, thus avoiding fees being paid at all three levels. Accordingly, the staff no-action position set forth in the letter represents a reasonable accommodation to issuers using conduit structures, particularly in the variable insurance products space. And, of course, this position will enable issuers to pass along to investors the benefit of lower share registration costs.
The staff also issued a no-action letter to the American Retirement Association this past February. This letter should enable registrants issuing variable insurance products to Section 403(b) plans to more easily meet certain legal and compliance obligations under Rule 482 under the Securities Act, the mutual fund advertising rule. In that letter, the staff agreed to treat certain investment-related information furnished to participants and beneficiaries by 403(b) plan administrators that are not subject to ERISA as Rule 482 advertisements, despite the fact that the materials would not fully comply with the Rule’s requirements regarding performance information. As a result of this letter, 403(b) plan administrators are better able to provide plan participants with sufficient information to make informed decisions when managing their accounts. This position is an extension of a no-action position previously provided to the U.S. Department of Labor regarding plan administrators that are subject to ERISA.[7] You can find these letters and the Jackson National letter on the Division of Investment Management’s website.
As I noted earlier, the asset management industry has grown and evolved since the enactment of the Investment Company Act. Obviously, Congress could not have anticipated all of the product innovation that would come about since 1940, which is why the Commission’s rulemaking authority has been so important in helping to ensure the Act’s effectiveness as a regulatory tool. The Commission’s rulemaking efforts were most recently highlighted with two proposals relating to registered funds. These proposals are part of a set of core initiatives being developed at the direction of SEC Chair Mary Jo White to address the increasingly complex portfolios and operations of today’s asset management industry. The first of these core initiatives is to formulate ways to improve the information received and used by the Commission to identify and respond to risks within the asset management industry. This initiative has resulted in the Commission’s proposal to amend Form ADV, and the Commission’s investment company reporting modernization proposal, which I will speak about in a few moments. The second core initiative is to adopt measures for funds to better identify and address risks relating to the composition of portfolio assets, such as liquidity risk management. I am also going to talk about specific actions the Commission has taken to address this initiative. The third core initiative relates to funds’ use of derivatives. The Division is currently developing a recommendation for the Commission’s consideration related to the use of derivatives by funds, including measures to appropriately limit the leverage these instruments may create, as well as enhancing risk management programs for such activities. Beyond that, the staff is developing recommendations regarding transition planning for advisers and annual stress testing by large investment advisers and funds.
In September, the Commission proposed a broad set of rule reforms designed to promote stronger and more effective liquidity risk management by open-end funds and enhanced disclosure regarding liquidity and redemption practices.[8] When a fund fails to adequately manage liquidity, it can experience disruption of portfolio management and higher costs in selling portfolio assets to meet its redemption requests. These costs can have significant adverse consequences on those investors remaining in the fund. Discounted sales prices can affect the fund’s net asset value and trading costs can potentially dilute the interests of remaining shareholders. Additionally, a fund’s risk profile may be adversely affected to the extent its portfolio becomes increasingly illiquid as more liquid assets are sold to meet redemption requests. Improved fund liquidity management and enhanced disclosure would advance the protection of investors, including variable contract owners who indirectly own fund shares held in variable separate accounts.
To reduce the risk that a fund would be unable to meet redemptions, and to minimize potential dilution of shareholder interests, the proposed rules would require open-end funds to establish comprehensive liquidity risk management programs. Under the program requirement, a fund would have to determine a minimum level of liquidity for the fund, based on an assessment and periodic review of the fund’s liquidity risk. A fund also would be required to categorize the liquidity of its portfolio positions and disclose the liquidity category assigned to each portfolio position. Additionally, the proposal would give open-end funds, except money market funds and ETFs, the option of using “swing pricing,” the process of adjusting a fund’s net asset value to help allocate costs arising from shareholders’ purchase or redemption activity to the shareholders associated with that activity.
It has been said that knowledge is power. The staff’s effectiveness in administering the securities laws is enhanced by greater intelligence about what is going on in the industry. Registered investment company assets have grown by more than 500% in the past twenty years.[9] Additionally in recent years, the asset-management industry has seen the development of new products and strategies, including funds that are pursuing “alternative” strategies and hybrid annuities offering both variable and indexed linked returns. As these industry changes and technological advances have occurred, we recognize a need to improve the type and format of information that funds provide to us and to investors. Accordingly, the Commission undertook a major rulemaking initiative this past spring to update and modernize certain rules and forms for registered investment companies and investment advisers.[10] These rules, if adopted, would enhance and improve the information provided by registered investment companies to the Commission and to the public, and would assist the Commission, as the primary regulator of the asset management industry, in carrying out its regulatory responsibilities. It seems quite fitting and timely to embark upon this key initiative to improve our regulatory framework as the Commission not only celebrates the 75th anniversary of the Investment Company Act, but also looks forward to the next 75 years.
In this context, the Commission proposed new Form N-PORT, which, if adopted, would require registered funds to report their portfolio holdings to the Commission on a monthly basis and in a structured — that is, machine readable - data format, which would allow the Commission, as well as investors and other potential users, to analyze portfolio investment data more efficiently both within a fund and across funds. Form N-PORT would require information not currently required to be reported on quarterly portfolio investment schedules, such as additional information on derivative instruments held in a portfolio. As the Commission noted in the proposal, new Form N-PORT would assist the Commission in better understanding risks in the fund industry, and the ability to understand the risks that funds face would help the staff to better understand and monitor risks and trends in the fund industry as a whole, which would facilitate informed regulation of the fund industry. In addition, the Commission proposed amendments to Regulation S-X, which, if adopted, would require enhanced and prominent disclosure regarding derivatives and securities lending activities in investment company financial statements.
The Commission also proposed new rule 30e-3, which, if adopted, would allow registered investment companies to transmit shareholder reports to investors by making the reports accessible on a website, subject to certain conditions designed to ensure that investors who want paper copies may continue to receive reports in that manner. Thus, the proposed rule would preserve investor choice of the format in which to receive information. We in the Division are carefully reviewing the many thoughtful comments that have been received about the proposed rule, including—perhaps of particular interest to this audience—comments about the application of the rule to fund shares held through an intermediary, such as an omnibus account or a variable insurance product.
Another piece of this data gathering initiative that is particularly significant is the proposed replacement of Form N-SAR with new Form N-CEN. The proposal to rescind Form N-SAR noted that in recent years the Commission staff had found that the utility of the information reported on Form N-SAR had become increasingly limited. Accordingly, new Form N-CEN would require data elements similar to those required by Form N-SAR, but would streamline and update information reported to the Commission to reflect current staff information needs and industry developments. Additionally, where possible, the Commission endeavored to exclude items from proposed Form N-CEN that are disclosed or reported pursuant to other Commission forms, or are otherwise available. The Form also would require a structured data format that could reduce reporting burdens for registrants and yield data that could be used more effectively by the Commission and other potential users. As with proposed Form N-PORT, the information on proposed Form N-CEN could help Commission staff better understand industry trends, inform policy, and assist in the Commission’s examination program.
The Commission has received many thoughtful comment letters in response to the modernization rulemaking, which are publicly available on the Commission’s webpage. I want to note that the Commission has reopened the comment period for this rulemaking in light of the impact the liquidity rule proposal would have on certain SEC forms. We in the Division greatly appreciate and will carefully consider the letters we receive on both of these proposals before making a recommendation for final action to the Commission. The rulemaking process is always enriched by the participation of investors, industry participants, and other stakeholders in the comment process.
The flexibility of the Investment Company Act has also allowed the Commission and its staff to develop regulatory guidance as needed. Over the past few years, the Division has been publishing periodic guidance updates to enhance its communications with the public. One update we recently published is a piece on cybersecurity,[11] which is a subject that impacts virtually all registered investment companies and their investors as reliance on information systems is now an integral part of everyday life. Variable product issuers and others rely on large and complex information systems to collect, process, and store personal contract owner data. The update highlights the importance of protecting confidential and sensitive client information and sets forth a number of measures that registered investment companies and registered investment advisers may want to consider regarding the risks relating to cybersecurity. The Division will continue to monitor cybersecurity matters, and the Commission’s Office of Compliance Inspections and Examinations has identified cybersecurity compliance and controls for broker-dealers, investment advisers, and transfer agents as one of its examination priorities.[12] I encourage you to read the cybersecurity guidance as well as our other updates, which are posted on the Division’s website.
Guidance from the staff has also been beneficial in clarifying issues that arise after the adoption of a new rule. Last year, the Commission adopted amendments to the rules that govern money market mutual funds.[13] As you probably know, the new rules require a floating net asset value for institutional prime money market funds and allow non-government money market fund boards to impose liquidity fees and redemption gates to address the risk of investor runs on money market funds. When the money market fund reform was proposed, the Commission received many thoughtful comments, including from representatives of the variable product industry who wanted to address issues relating to funds offered through variable insurance contracts. A provision was added to the adopted money market fund rule to clarify that a variable insurance contract may apply a liquidity fee or redemption gate to owners invested in a money market fund subaccount, notwithstanding the requirement under the Investment Company Act that a variable insurance contract be a redeemable security. This past spring, the Division staff prepared a series of Frequently Asked Questions on issues related to the money market fund reform, which can be found on the Division’s website and which the staff expects to update from time to time as additional questions are asked.[14] One section of the FAQs relates specifically to insurance separate accounts, providing questions and answers relating to “look through” issues, the imposition of liquidity fees, and the emergency suspension of redemptions at the separate account level.
I trust that these FAQs have been helpful to those managing money market funds and to the insurance companies that offer such funds through their products. Over the past year and a half, the staff has been monitoring developments with regard to the money market fund rule amendments, including developments relating to money market funds offered through variable products. During this time, the staff has observed a small number of insurance money market funds liquidate, and has seen several insurance prime money market funds transition to government money market funds. As the October 2016 compliance date for the implementation of floating NAV, liquidity fees, and redemption gates approaches, the staff will continue to monitor developments and work hard to provide additional guidance as needed.
Before I close, let me once again remark on how this year marks an exciting time in the history of the Investment Company Act as we celebrate its 75th anniversary. The statute, while rather exceptional in achieving its goal of investor protection, was enacted during a simpler time, and Congress could not have foreseen the innovative products in the marketplace today. It is part of our job at the Division to facilitate such innovations, consistent with the protection of investors. To that end, the Division is working to facilitate registrants’ compliance with their legal and regulatory obligations under the Act, improve the regulatory framework under the Act, and provide enhanced guidance to registrants. With that in mind, the staff values input from investor, industry, and other stakeholders. As always, you are encouraged to contact the staff with questions, comments, and ideas you may have.
Thank you and enjoy the rest of the conference.
[1] I would like to thank my colleagues Susan Nash, William Kotapish, and Elisabeth Bentzinger for their invaluable expertise in the preparation of these remarks. The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed herein are those of the author and do not necessarily reflect the views of the Commission or of the author’s colleagues on the staff of the Commission.
[2] See Investment Company Institute, 2015 Investment Company Fact Book 9 (55th ed., 2015), available at http://www.ici.org/research/stats/factbook.
[3] Based on staff analysis of Form N-SAR filings.
[4] See Jackson National Life Insurance Company, SEC Staff No-Action Letter (July 9, 2015), available at http://www.sec.gov/divisions/investment/noaction/2015/jackson-national-life-070915.htm.
[5] American Retirement Association, SEC Staff No-Action Letter (Feb. 18, 2015), available at http://www.sec.gov/divisions/investment/noaction/2015/american-retirement-sssociation-021815-482.htm.
[6] See, e.g., Instruction C.3 to Form 24F-2 (an underlying fund may exclude securities sold to a unit investment trust that offers interests that are registered under the Securities Act of 1933 and on which registration fees have been or will be paid); GMO Trust, SEC Staff No-Action Letter (May 24, 2012); available at http://www.sec.gov/divisions/investment/noaction/2012/gmotrust052412-24f2.htm (master funds may exclude the net sales price of shares sold to feeder funds when calculating aggregate sales proceeds for purposes of Rule 24f-2).
[7] Department of Labor, SEC Staff No-Action Letter (Oct. 26, 2011), available at http://www.sec.gov/divisions/investment/noaction/2011/dol102611-482.htm.
[8] Open-End Fund Liquidity Risk Management Programs; Swing Pricing; Re-Opening of
Comment Period for Investment Company Reporting Modernization Release, Investment Company Release 31835 (Sept. 22, 2015), [80 FR 62273 (October 15, 2015)], available at http://www.sec.gov/rules/proposed/2015/33-9922.pdf.
[9] See Investment Company Institute, 2015 Investment Company Fact Book 9 (55th ed., 2015), available at http://www.ici.org/research/stats/factbook.
[10] Investment Company Reporting Modernization, Investment Company Act Release No. 31610 (May 20, 2015) [80 FR 33590 (June 12, 2015)], available at http://www.sec.gov/rules/proposed/2015/33-9776.pdf; Amendments to Form ADV and Investment Advisers Act Rules, Investment Advisers Act Release No. 4091 (May 20, 2015), [80 FR 33717 (June 12, 2015)], available at http://www.sec.gov/rules/proposed/2015/ia-4091.pdf.
[11] Cybersecurity Guidance, IM Guidance Update No. 2015-02 (Apr. 2015), available at http://www.sec.gov/investment/im-guidance-2015-02.pdf.
[12] Examination Priorities for 2015, Office of Compliance Inspections and Examinations, available at http://www.sec.gov/about/offices/ocie/national-examination-program-priorities-2015.pdf; see also OCIE’s 2015 Cybersecurity Examination Initiative, National Exam Program Risk Alert (Sept. 15, 2015), available at https://www.sec.gov/ocie/announcement/ocie-2015-cybersecurity-examination-initiative.pdf.
[13] Money Market Fund Reform; Amendments to Form PF, Investment Company Act Release No. 30551 (June 5, 2013), [78 FR 36834 (June 19, 2013)], available at http://www.sec.gov/rules/proposed/2013/33-9408.pdf.
[14] 2014 Money Market Fund Reform Frequently Asked Questions (revised August 4, 2015), available at http://www.sec.gov/divisions/investment/guidance/2014-money-market-fund-reform-frequently-asked-questions.shtml.